It’s hard to miss the stench of doom hanging over many developing countries right now. Some are even predicting another big nasty emerging-markets crisis akin to those in the late 1990s and 1980s. Can anything be done?
Perhaps. Our colleague Martin Wolf has highlighted an intriguing proposal on how to address the budding wave of sovereign defaults from two of the field’s more prominent experts.
Aside from being an occasional FT Alphaville contributor, Lee Buchheit is the pre-eminent sovereign debt lawyer, having over the past four decades represented almost every major country to have gone bust. (He is also the only one we know of to have written a Dr Seuss style poem about how to negotiate payment default clauses.) Co-author Adam Lerrick has been involved in US international financial policy since the early noughties, and was most recently acting US executive director at the IMF and a counsellor to Treasury Secretary Steven Mnuchin.
So what are they proposing? Basically a modern-day version of the Brady Plan that helped banish the 1980s EM debt crisis, with two options for creditors to choose from:
Under the Cash Down-Payment Structure exchange, investors will receive an immediate cash downpayment of their existing bonds equal to 30-35% of the bond’s current market value plus a new standard long-term bond of the government with no write-down of the principal amount of the bond. The investor recovers a significant portion of the market value of its holding in cash immediately and has a new bond of a borrower with a now sustainable debt. The sum of the cash down-payment and the market value of the New Bond will be significantly higher than the current market value of the government’s external bonds.
Under the Floor of Support Structure exchange, the investor will receive a new long-term bond of the government (again, with no write-down in principal amount) that includes a rising AAA-rated floor of support with an initial value of 60-70% of the current market value of the existing bonds. The AAA minimum value is based upon the investor’s ability to exchange its New Bond into a long-term World Bank (or other AAA-rated issuer) zero-coupon bond at any time. The accreted value of the zero coupon bond will rise over time to 100% of the nominal amount of the New Bonds at their maturity. Under the Floor of Support Structure, the investor will have a secure minimum value for its holding that protects against one of the main risks of emerging market sovereign bonds (a catastrophic fall in the value of the instrument). The market value of the New Bond with its floor of support will be significantly higher than the current market value of the government’s external bonds.
Buchheit and Lerrick estimate a reduction in the net present value of a country’s debt by over 50 per cent, enough to make a country’s debts sustainable. You can find the full proposal here. Make sure to check out the appendix, which details the proposed T&Cs of the two structures in a hypothetical scenario of a $10bn debt stock.
But will it work?
Two of the central challenges of debt crises can be pithily summed up as the “too little, too late” phenomenon. Here’s an October 2022 IMF seminar on it featuring among others Gita Gopinath, Buchheit, the FT’s own Wolfy and a cameo from some protesters.
Basically, countries are as a rule incredibly reluctant to default. Rather than reneging willy-nilly, they usually stay in denial for far too long, which merely prolongs the crisis and makes the pain worse for everyone involved when they finally accept the inevitable. As law professor Anna Gelpern said in the IMF seminar:
Countries insist on paying. They insist on paying through pandemics, through famines, through wars. (Even) when the payment systems are closed to them they try to finagle their way into paying.
Even when they do default and restructure, countries often want to be seen as at least somewhat responsible and reach a semi-amicable restructuring agreement with creditors. As a result, that debt relief is often too minimal to secure a durable turnround, which leads to lost decades of growth and repeat defaulters.
The Buchheit-Lerrick proposal is aimed mostly at the “too little” bit. If the public sector agrees to backstop the debt exchanges and creditors acquiesce, then countries would in practice should get enough debt relief to minimise the risk of repeated defaults.
They hope that this will in turn help the “too late” part. One of the things that deters countries from restructuring their debts is wariness over what is often an incredibly messy process. Having a simple template that offers real financial succour might entice a few into a more proactive approach. As Lerrick told FTAV:
The proposal attempts to address the fundamental flaw in the sovereign debt restructuring process for poor countries. None of the key actors are focusing on a solution that will ensure long-term debt sustainability and economic growth that will improve the lives of the debtor nation’s people.
The primary goals of the debtor government are to obtain an IMF loan and survive to the next election.
The primary goal of the IMF is stability during the 3-7 year IMF program period.
The primary goal of the bondholders is to minimise their immediate losses.
The primary goal of the official bilateral lenders is to push the problem into the future.
. . . the primary goals of the main actors leads to insufficient debt relief, unsustainable debts over the long term, a continuing repeat of the crisis-debt restructuring cycle, economic stagnation and poverty. Under the proposal, the [international financial institutions] provide funds to shift the outcome of the restructuring to a solution that provides far greater debt relief and a debt that is sustainable over the long term.
The Buchheit-Lerrick proposal also attempts to address another common problem, what the former has dubbed the “financial bulimia” of sovereign debt.
Even when a country secures a lot of debt relief — such as through the Heavily Indebted Poor Countries debt relief initiative — and sets itself up for a durable recovery it is often quickly tempted back to the bond market and leverages itself up again.
The proposal therefore suggests that the international financial institutions that backstop the restructurings insert clauses that require early repayment of their loans should the country start tapping investors for new loans. Here’s what Buchheit told FTAV:
. . . It does little to help over the longer term if the local politicians can simply use the balance sheet cleansing that results from the transaction to bulk up again on non-concessional debt. This what I call the “financial bulimia” character of sovereign debt; periods of over borrowing followed by disagreeable purgings in the form of debt restructurings followed by more overborrowing, and so forth and so on.
This was the great failing of HIPC. Take the case of Ghana. Ghana graduated from HIPC in 2006 with a debt service to government revenues ratio of 10 per cent. It is now about 70 per cent and a new purging is required.
Adam and I propose that any comprehensive debt relief resulting from a transaction along the lines we suggest be accompanied by features that will at least hinder the politicians from another bout of binge eating in the bond market. Because we are dealing with sovereigns, nothing can absolutely prevent a return to fiscal mismanagement but it can be hindered, at least for a while.
Noodling this a bit we think we can still see some issues, unfortunately.
Firstly, while the multinational organisations like the World Bank and IMF are able and probably willing to play the same role that the US played in the Brady Plan, bondholders are never going to be as pliant as banks were back in the day.
Banks could be leaned on by their governments to “do the right thing”, something that is far harder if not impossible with an atomised group of international bondholders that have a fiduciary duty to play hardball. In reality, many will always reckon they can get a better financial recovery than what the Buchheit-Lerrick plan offers, no matter how grim the economic reality. Greed Hope springs eternal.
Secondly, there are perennial inter-creditor issues. The proposal only deals with external debts. But what about local bonds, which can also be a huge burden for a lot of countries? And what about near-term versus longer-term securities? If you own a 20-year bond you might be OK with rolling that into a 30-year one, but if you own a security due for repayment soon then you’ll be a bit less enthusiastic for either option.
And how do you solve the increasingly thorny problem of Chinese loans? Are Western bondholders willing to get cajoled into a debt restructuring along these lines while Chinese state-owned banks clip coupons unmolested?
Most of all, the disparate drivers of “too little too late” — those identified by Lerrick above — are probably too pernicious to be overcome by even an innovative and worthy initiative like this. Countries simply don’t like defaulting even if they obviously should. And if they eventually do succumb then creditors fight tooth and nail for every cent on the dollar.
Just look at Ukraine. Has there ever been a country with a better excuse for a debt restructuring, and more likely to receive a better hearing from creditors? Had Kyiv last year told the owners of its $20bn of bonds that they would only get half back, and that only over a long time period, not one major creditor would have dared to balk, given Ukraine’s dire situation and the political backdrop. Instead, Ukraine merely sought a two-year payment freeze.
But realistically there will never be a silver bullet when it comes to sovereign debt restructurings. Could the Buchheit-Lerrick proposal at least help some countries? Probably. So like Martin, FTAV reckons it’s worth a shot.
